Mutual funds gained popularity among the investing public in the 1980s and 1990s. They began as a way for large institutional investors to pool their money for a common purpose and spread the risk of losses inside a mutually-owned fund, hence the name mutual fund.
What you may not be aware of is that there are various types of mutual funds. The two main ones are open-end and closed-end. Understanding the differences between them can help you broaden and strengthen your investment portfolio asset allocation based on your investment risk tolerance.
What Are Open-End Mutual Funds?
Like all funds, open-end mutual funds — open-ended funds or OEFs — pool investments from a group of individual investors. The investment company, made up of a fund manager, professional traders, and analysts, will then invest the money pooled from the group of investors according to the prospectus for the fund.
Open-end funds are unique because they don’t have restrictions on the number of shares they can issue to new investors. Instead, when investors want in, these funds simply issue new shares and accept the investment directly.
There is a caveat.
These funds must buy shares back from investors who wish to exit their investment. As a result, the value of each share of these funds is based on the net asset value (NAV) of the fund, or the value of the fund’s assets, rather than on how much investors are willing to pay for it.
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What Are Closed-End Mutual Funds?
Closed-end funds, also known as closed-ended funds or CEFs, and open-ended funds appear to be the same type of investment in many ways. They are built on the idea of diversification, pool investment dollars from a large group of individual investors, and are generally managed by a team of Wall Street pros.
But, when you dial into the details, you’ll find that OEFS and CEFS are actually quite different.
Closed-end funds trade on stock market exchanges, so buying and selling shares of these funds takes place in the same way that buying and selling shares of stock does.
Like any publicly traded company, closed-end funds have a fixed number of shares and can’t simply issue new shares because there’s demand. Moreover, closed-end funds don’t repurchase their own shares when an investor wants to exit his position.
From the date of its initial public offering (IPO), closed-end mutual funds trade just like stock for all intents and purposes.
When deciding which type of fund is the best fit for your portfolio, there are several factors that need to be taken into account, with your financial goals being foremost.
It’s important to think about your time horizon, how your investing dollars will be used to achieve growth, and what factors play a role in the pricing of these assets.
Liquidity describes the amount of time it will take to turn an investment back into cash by selling it to another investor or back to the issuer.
If you’re looking to make short-term investments or think you may need access to your investing dollars from time to time, you’ll benefit from the ability to quickly turn your investments into cash.
If you have a long time horizon and use a buy-and-hold strategy, liquidity may be less of a concern for you.
Open-End Fund Liquidity
Open-end mutual funds are generally liquid assets because fund managers are required to hold a percentage of the fund’s assets in cash for any investors who want to redeem their investments.
As a result, if you want to exit an open-end investment, you’ll be able to do so at the end of each trading day by selling your shares back to the fund management company that issued them to begin with.
Closed-End Fund Liquidity
Closed-end funds aren’t always able to be redeemed at the end of the day. These are exchange-traded funds (ETFs) that are at the mercy of the levels of supply and demand among investors.
When a closed-end fund launches its IPO, it puts a prespecified number of shares up for sale, and it generally doesn’t issue new shares or redeem old shares. Instead, in order for one investor to sell a position in these funds, another investor needs to be willing to buy it.
If there are no buyers wanting into the fund when you’re ready to sell your shares, you won’t be able to sell. Instead, you’ll be forced to hold until a buyer comes along.
As a result, these funds have the potential to be less liquid than their open-end counterparts, especially if you invest in a smaller fund with low levels of trading volume.
When investing, whether it be in stocks or investment-grade funds, share price is an important factor. After all, you don’t want to overpay and lose the opportunity to generate meaningful gains.
When it comes to closed-end and open-end mutual funds, it’s important to understand how prices are set for these investments and what that means for you if you have them in your portfolio.
Open-End Fund Pricing
The price per share of an open-end fund is based on its NAV at the end of each trading day. After the markets close, the fund’s NAV is divided by the total number of outstanding shares to get the share price of the fund.
For example, if a fund has a NAV of $100 million and there are currently 1 million shares issued, the price for each share will be $100 ($100 million divided by 1 million shares).
As a result of this pricing structure, open-end investments are known to experience lower levels of volatility, making them a safer investment when compared to closed-end opportunities.
Closed-End Fund Pricing
The pricing of closed-end investments works quite differently because they are exchange-traded assets. As with any other asset traded on stock market exchanges, the market price of these funds is determined by the law of supply and demand.
Supply is created by investors who want to sell shares of the fund, while demand is created by those who want to buy shares.
If the buying pressure outweighs the selling pressure, the law of supply and demand stipulates that the price of the asset must rise to curb demand. If supply outweighs demand, prices must fall to increase demand and create a balance.
Although the way closed-end investments are priced creates volatility and increased risk, it also creates opportunity.
There may be several reasons that supply outpaces demand. Sometimes it’s as simple as investors being unaware that the opportunity exists. In these cases, the price of shares of a closed-end fund can actually fall below its NAV — the value of the underlying assets it owns — meaning you’ll have the opportunity to buy in at a discount.
As a result, closed-end funds make it possible to boost capital appreciation by taking a value investing approach to mutual funds.
3. Capital Structure
The distribution of debt and equity within a publicly traded asset is known as its capital structure. One of the most important factors in this structure is how many shares are outstanding, which can either be a fixed or floating number, depending on the type of fund you invest in.
Open-End Fund Capital Structure
Open-end investments have no restrictions on the number of new shares that can be issued if a new investor or group of investors want to get involved. This means the number of outstanding shares will change on a daily basis as new investors purchase shares and prior investors redeem their shares.
This can create a challenge for fund managers that ultimately increases risk. If a fund becomes too large, the fund manager may decide the total assets have grown too unwieldy to make it possible to meet the fund’s objectives. This can result in the manager closing the fund to newcomers, leading to potentially lower prices and slower growth in the fund.
A fund growing too large can also increase the risk for investors if it means the team managing the investments may be stretched to their limits and more prone to mistakes.
Closed-End Fund Capital Structure
Closed-end investments trade on the open market with a specific number of shares available. Their capital structure is much easier to understand. Moreover, even as demand grows, the net asset value of the fund will remain manageable for the team at the helm.
On the other hand, the downside to this capital structure is that if demand for a fund is high, you’ll have to overpay in relation to the fund’s NAV in order to get involved in the investment.
When deciding if you’ll invest in an open-end or closed-end investment, it’s also important to consider the accessibility of the investment. In some cases, funds can come with exorbitant minimum investments, resulting in less accessibility for everyday investors.
Buying and Selling Open-End Funds
The price of open-end shares is set by the fund manager at the end of the day, and you’ll often be required to meet minimum investment amounts to get involved.
Minimum investment amounts generally range from $500 to $5,000, with funds at the higher end of the spectrum being less accessible for new investors with relatively small investment portfolios.
Buying and Selling Closed-End Funds
Closed-end investments are priced based on supply and demand, with the minimum investment amount being no more than the cost of a single share of the fund.
The vast majority of these funds are priced from $10 per share to a couple of hundred dollars per share, making them far more accessible to newer investors with limited capital available.
When you make an investment, you want 100% of your money to be put to work for you, exposed to the potential gains — or losses for that matter.
However, depending on which type of mutual fund you choose, the money you invest may not be 100% exposed to the assets you’re investing in.
Open-End Fund Investing Capital Exposure
To exit a position in an open-end fund, investors sell their shares back to the issuer. This means the company managing the fund has to hold a percentage of the fund’s assets in cash to the side so that it can afford to purchase shares back when an investor decides to exit their investment.
That cash set aside for redemptions can’t be put to work in the market.
Therefore, when investing in open-end mutual funds, a percentage of your investment will not be exposed to the underlying assets outlined in the fund’s prospectus, limiting your profitability.
Closed-End Fund Investing Capital Exposure
Closed-end investments provide 100% exposure to the underlying assets. That’s because these shares are bought and sold in the open market in transactions between investors, not between the issuer and investors.
Because there is no requirement for the issuer to buy shares back from the investing public, 100% of your investment dollars can be invested based on the objectives of the fund.
The Verdict: Should You Choose Open-End or Closed-End Funds?
Deciding whether you’ll invest in an open-end or closed-end fund is a decision that requires a bit of thought.
How comfortable are you with risk? Are you going to need access to your funds quickly? Do you find solace in being able to access those funds or would you rather enjoy a potential discount when you purchase shares?
You Should Invest in Open-End Assets If…
Consider open-end funds if you prefer investments that have high liquidity and, although growth may be slower, you’re more interested in assets that lack volatility. OEFs may be best for you if:
- You Have a Shorter Time Horizon. If you aren’t planning on investing for the long haul or may need access to your investing dollars from time to time, open-end investments offer the perfect solution. They are generally redeemable at the end of each trading day, meaning you’ll have access to your money when you need it.
- You Have Enough Capital to Get Started. Fund managers set minimum investment amounts for open-end funds ranging from $500 to $5,000. Investors in these funds need to have enough money to cover these minimum capital requirements.
- You’re Risk-Averse. Volatility is exciting for some investors because it offers the opportunity for large gains over a short period of time. On the other hand, it also has a dark side because it increases the risk of sudden, significant losses. Investors with a relatively low appetite for risk will benefit from investing in open-end opportunities because they tend to experience far less volatility than their closed-end counterparts.
You Should Invest in Closed-End Assets If…
Consider closed-end funds if you enjoy doing the research to find undervalued opportunities and sitting on them until their values climb to more realistic levels. You might be a good fit for closed-end funds if you don’t mind moderate levels of risk in exchange for the potential to expand your gains.
Closed-end funds are best if:
- You Enjoy Volatility. Although fast-paced fluctuations in the price of an asset will result in risk, it also gives you the opportunity to take advantage of discounts when funds are undervalued and cash in on big gains when investors push the values of the funds too high.
- You Invest With a Long Time Horizon. Closed-end assets are riskier than open-end assets, which is fine for those with a long time horizon. The longer you plan on staying invested, the longer you have to make up for declines should something go wrong.
- You Aren’t Worried About Liquidity. Closed-end assets are only able to be sold when another investor is interested in purchasing them. If there’s no buyer, you’ll be stuck in the investment until one comes along, making closed-end funds — especially lesser-known funds that are thinly traded — less liquid.
- You Don’t Have a Large Portfolio. While open-end assets generally come with high minimum investment amounts, closed-end assets only require you to invest as much as a single share of the fund costs, which is often minimal. This makes closed-end funds well-suited for investors with relatively small portfolios.
Both Are Great If…
Some investors own a mix of the two types of mutual funds. These investors usually have relatively large investing portfolios and want access to the potentially market-beating returns of closed-end funds while hedging those bets with the safer open-end funds.
You might consider a mix of the two types if:
- You Have a Mild Tolerance for Risk. If you want to get your hands on the increased profitability offered by the higher volatility closed-end funds, but aren’t willing to take this higher level of risk across your portfolio, a mix of both closed- and open-end funds will provide balance.
- You Have a Relatively Large Investing Portfolio. In order to mix closed-end and open-end funds within your portfolio, you’ll have to have enough capital to do so. In general, you’ll need a portfolio with a minimum of $10,000 to properly diversify between the two.
- You Want Some Liquidity. Say you believe you might need fast access to your money in some cases, but chances are you won’t need to access it all at once. In this case, open-end opportunities can make up the most liquid portion of your portfolio, while the rest of your portfolio can be invested in closed-end assets with a higher earnings potential.
By now, you should have everything you need to decide whether an open-end mutual fund, closed-end mutual fund, or a mix of the two is best for your investing portfolio. Now, it’s time to act.
Keep in mind that mutual funds are each unique, offering different rates of return, expense ratios, and investment strategies. As a result, it’s important to do your due diligence by researching every investment opportunity prior to investing your hard-earned money.